Price to Earnings and FCF Yield

There is a rise in the general views on valuation that the equity valuation overall is getting stretched. Let’s focus on price to earnings and FCF yield and find if this is the case.

Overall, the trend is moving upwards. PER increased from 09 to 14 more than from 14 to today, except energy and consumer staples. From 14 to today, the multiple changes are flattish for sectors ex-energy, which is the exceptional outlier, led exclusively to the recent rise in PER of the whole market.

The free cash flow yield is heading lower. The chart below shows the US 10 year government bond yield and the last 12-month free cash flow yield of S&P 500 companies since 1990.



Price to Earnings



FCF Yield


So it appears that valuation is getting less inexpensive. The question is if we need to start to pay attention and get cautious.

I do not think that is the case. Let’s frame it in the long term context, not under the short-sighted – several quarters – view.

First, since the financial crisis, free cash flow yield has been trending and remaining at a higher level than in the pre-financial crisis period.

Why did this happen? In the post-financial crisis era, a new trend emerged, and I gave it a name: “post-crisis disciplined and lean management of the economic return on capital.”

Take a look at the debt-equity ratio (i.e., the financial leverage) trend of the equity indexes since the 90s.



Capital Structure


They behave differently since the financial crisis. Clearly, the financial crisis had a significant impact. Less fundraising through debt has naturally forced more financing from equity while increased incentives to generate more cash from business operations. Some companies even achieved a sub-zero cash conversion cycle. Companies were forced to get disciplined to lean toward the shareholders’ goals, which contributed to raising profitability without using financial leverage.

As in the above chart, the US debt to equity ratio has decreased from 200% to 100% in the post-financial crisis era, return on equity increased, and it should be noted that cash flow from operations has more than doubled.

Just add that there is a misleading observation that corporate debt is growing fast and approaching to the pre-crisis level, which indicates financial risk is returning.

If you take a look, the corporate debt is surely coming back but equity growth is much faster. So, debt to equity ratio as well as debt to EBITDA ratio indicate that the overall credit market is healthy.





Liquidity is getting more and more abundantly supplied, but financial credit is not. Credit has got more selective. All these challenging environments were sure to become headwinds, but the business responded smartly and flexibly enough to grow strongly and exceed the profitability in the pre-financial crisis era.

Now go back to the FCF yield. Even though the current 5.3% FCF yield of S&P 500 was lower than the last couple of years (7% in June 2013 and 5.7% in June 2014), I do not think this is the level that would lead to concerns that equity valuation is overstretched.

In fact, we have not had a significant stock market correction at such a high level of free cash flow yield in the last 25 years. Historically, all equity market corrections took place around FCF of 2%. Also, given that the current market aggregate FCF yield includes a significant negative yield from the commodity-related cyclical companies, the cyclicality adjusted FCF yield, which works a more reasonable indicator for the normal level, is even higher.

The average spread between FCF Yield and the government bond yield since June 2009 is 4.64%. While the current FCF yield spread of 3.82% is lower than the post-crisis average, it does not send a red signal from a historical & cross-asset valuation perspective. It is within the historical range.

There is a very slim chance for secular inflation to pick up. The leading driver of inflation ex-energy has been high value-added service sectors such as professional service, education, and healthcare. While deflationary industries such as apparel and consumer technology products remain so, the backlash against the high cost of high value-added services has increased significantly. Extending it in five to ten years would lead to an unrealistically high price, which is not acceptable given the slow wage growth environment.

On the other hand, FCF is stable or moderately picking up. First, it will be cyclically led by the announced many capex cuts of energy & material-related companies, many of which face a harsh demand/supply environment. That will create at least a buffer to offset potential interest rate hikes if there is any. Second, as touched earlier, there emerged a structural and secular engine that actively drives economic profit much more robust than before as an outcome (or a response) of the financial crisis.

The bottom line is that FCF yield spread is supported by the combination of:

a) the structural trend of free cash flow growth
b) the low yield due to inflation and the central bank behaviors

The equity investment will keep going, and it is not only that.

The post-financial crisis era had a positive structural shift that turned out to be strongly positive for equity investing, a key reason why the equity cycle is extending further.


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